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I have always wanted to promote the work of young scholars on this blog and have been grateful that a couple of gifted young economists have published guest posts on this blog. I want to continue that “tradition” and I am therefore happy that Garrett Watson – a student of Steve Horwitz at St. Lawrence University – has accepted my invitation to write a guest post for my blog.

Enjoy Garrett’s excellent discussion about the “Misunderstanding Say’s Law of Markets”. The post has previously been published on Tu Ne Cede Malis.

Understanding Say’s Law and the connection to monetary policy is key to understanding the present crisis. So enjoy Garrett’s guest post.

Lars Christensen

Guest post: Misunderstanding Say’s Law of Markets

– By Garrett Watson, St. Lawrence University

Few ideas in the history of economic thought have achieved a level of perplexity and criticism than Say’s Law. Perhaps one of the most misunderstood and elusive concepts of the Classical economics, Say’s Law of Markets, first postulated by John Baptiste Say in 1803, underwent considerable support and eventual decline after its assault by John Maynard Keynes in The General Theory. Many of the fundamental disagreements we observe in historical debates surrounding macroeconomics can be traced to different conceptions of how Say’s Law operates in the market economy and the scope used in the analysis. By grasping a thicker idea of Say’s Law, one is able to pinpoint where disagreements in both macroeconomic theory lie and judge whether they necessarily must be dichotomized.

Say’s Law is best known in the form Keynes postulated it in The General Theory: “supply creates its own demand” (Horwitz 83). Despite the apparent eloquence and simplicity contained in this definition, it obscures the genuine meaning of the concept. For example, one may interpret this maxim as meaning that whenever one supplies a good or service, it must be demanded – this is clearly untrue (83). Instead, Say’s Law can be interpreted as saying that the ability to produce generates their ability to purchase other products (84). One can only fully grasp Say’s Law when analyzing the nature of the division of labor in a market economy. Individuals specialize in producing a limited range of goods or services, and in return receive income that they use to buy goods and services from others. The income one receives from production is their source of demand. In other words, “all purchasers must first be producers, as only production can generate the power to purchase” (84). This idea is intimately linked to the Smithian idea that the division of labor is limited by the extent of the market (89).

The result of this fascinating principle in the market economy is that (aggregate) supply will equal (aggregate) demand ex ante as demand is equally sourced by previous production (Sowell 40). Another important point made by Say’s Law is that there exists a trade-off between investment and consumption (40). In contrast to the later Keynesian idea of falling investment leading to a fall in consumption and therefore aggregate demand, an increase in investment means falling consumption, and vice versa. This idea can be analogized to Robinson Crusoe abstaining from consumption to build a fishing net, increasing his investment and his long-term consumption of fish (42). Therefore, a higher savings rate pushes up investment and capital accumulation, increasing growth and output (as Smith eloquently argues) (40). In another stark contrast to Keynesian analysis, there is only a transactions demand for money, not a speculative nor a precautionary demand (40). The implications of this are that money cannot affect real variables; it is a veil that facilitates transactions only – money is neutral (Blaug 148). Finally, Say’s Law also shows that there cannot exist a “general glut”; an economy cannot generally overproduce (Sowell 41). Whilerelative over and under-production can occur, there is no limit to economic growth (41).

While it was uncontroversial among the Classical economists that there wasn’t a limit on economic growth, several economists took issue with the fundamental insights of Say’s Law (44). One of the most well-known criticisms was that of Thomas Malthus. Malthus was an early proponent of the “Paradox of Thrift” – an excessive amount of savings could generate an economy with less than full employment (43). One could describe the view of Malthus as fundamentally “under-consumptionist” (Anderson 7). Unlike his contemporaries, Malthus did not view money as inherently neutral (Sowell 41). Other classical economists, such as Smith, argue that money “will not be allowed to lie idle”, effectively dismissing a precautionary motive for holding money and therefore monetary disturbances (38). This is where we see the inherent difference in perspective in the analyses of Smith and Malthus. Smith is focused on long-run conditions of money (its neutrality and importance of real fundamentals) versus the short-run disturbances money can generate in output (39).

Money is half of every exchange; a change in money can therefore spill over into the other half of every exchange, real goods and services (Horwitz 92). In effect, “The Say’s Law transformation of production into demand is mediated by money” (92). This means that Say’s Law may not hold in conditions in which monetary disturbances occur. John Stuart Mill recognized this possibility and affirmed Walras’ Law: an excess of money demand translates to an excess supply of goods (Sowell 49). An excess money demand manifests itself by individuals attempting to increase their money balances by abstaining from consumption. This therefore generates an excess supply of goods, which some would argue can be self-correcting, given downward adjustment of prices (Blaug 149). Malthus (and later on, Keynes) argues that downward price and wage rigidities (which can be the result of game theoretic problems in firm competition, efficiency-wages, or fixed wage contracts) can short circuit this process, yielding a systematic disequilibrium below full employment (Sowell 65). In terms of the equation of exchange, instead of a fall in V (and therefore a rise in money demand) being matched by a fall in P, the fall in V generates a fall in Y. This point was taken into further consideration by later monetary equilibrium theorists, including Friedman, Yeager, and Hutt.The same analysis can be used to understand the effects of drastic changes in the money supply on short term output, as Milton Friedman and Anna Schwartz would demonstrate in the contraction of the money supply during the formative years of the Great Depression

When analyzing the large disagreements over Say’s Law, it becomes clear that they stem from a difference in scope: supporters of Say’s Law analyzed the macro economy in terms of long-run stability, while Malthus and others after him focused on short-run disequilibrium generated by monetary disturbances (Sowell 72). Smith and other classical economists, pushing back against mercantilist thought, emphasized that money was merely a ‘veil’ that does not affect economic fundamentals, and that quantities of money ultimately didn’t matter (72). The Malthusian grain of truth regarding disequilibrium caused by monetary disturbances in the short-run does not refute Say’s Law; it reveals the necessity of getting monetary fundamentals correct in order for Say’s Law to cohesively operate. It becomes increasingly clear that once we look at the disagreements through the lens of scope, the two conceptions of the role of money in a market economy need not necessarily be incompatible.

Over the last couple of days I have done a couple of posts on the work of David Eagle (and Dale Domian). I guess that there still are a few posts that could be written on this topic. This is the next one.

Even though David Eagle’s work has been focusing on what he and Dale Domian have termed Quasi-Real Indexing I believe that his work is highly relevant for Market Monetarists. In this post I will try to draw up some lessons we can learn from David Eagle’s work and how it could be relevant to formulating a more consistent micro-foundation for Market Monetarism.

There are a no recessions in a world without money

The starting point in most of Eagle’s research is an Arrow-Debreu model of the world. Similarly the starting point for Market Monetarists like Nick Rowe and Bill Woolsey is Say’s Law – that supply creates its own demand. (See for example Nick on Say’s Law here).

This starting point is a world without money and both in the A-D model and under Say’s Law there can not be recessions in the sense of general glut in the product and labour markets.

However, once money and sticky prices and wages are introduced – both by Market Monetarists and by David Eagle – then we can have recessions. Hence, for Market Monetarists and David Eagle recessions are always and everywhere a monetary phenomenon.

N=PY – the simple way to illustrate some MM positions

In a number of his papers David Eagle introduces a simplified version of the equation of exchange where he re-writes MV=PY to N=PY. Hence, Eagle sees MV not some two variables, but rather as one variable – nominal spending (N), which is under the control the central bank. This is in fact quite similar to Market Monetarists thinking. While “old” monetarists traditional have assumed that V is constant (or is “stationary”) Market Monetarists acknowledges that this position no longer can be empirically supported. That is the reason why Market Monetarists have focused on the right hand side of the equation of exchange rather than on the left hand side like “old” monetarists like Milton Friedman used to do.

I, however, think that Eagle’s simplified equation of exchange has some merit in terms of clarifying some key Market Monetarist positions.

First of all N=PY gets us from micro to macro. Hence, PY is not one price and one output, but numerous prices and outputs. If N is kept constant that is basically the Arrow-Debreu world. That illustrates the point that we need changes in N to get recessions.

Second, N=PY can be a rearranged to P=N/Y. Hence, inflation is the “outcome” of the relationship between nominal spending (N) and real GDP (Y). In terms of causality this also illustrates (but it does not necessary prove) another key Market Monetarist point, which often has been put forward by especially Scott Sumner that nominal income (N) causes P and Y and not the other way around (See here and here). This is contrary to the New Keynesian formulation of the Phillips curve, where “excessive” growth in real GDP relative to “trend” GDP increases “price pressures”.

Third, P=N/Y also illustrates that there are two sources of price changes – nominal spending (N) and supply shocks. This lead us to another key Market Monetarist position – also stressed strongly by David Eagle – that there is good and bad inflation/deflation. This is a point stressed often by David Beckworth (See here and here). David Eagle of course uses this insight to argue that normal inflation indexing is sub-optimal to what he has termed Quasi-Real Indexing (QRI). This of course is similar to why Market Monetarists prefer NGDP targeting to Price Level Targeting (and inflation targeting).

The welfare economic arguments for NGDP targeting

In an Arrow-Debreu world the allocation is Pareto optimal and with fully flexible prices and wages changes in N will have no impact on allocation and an increase or a drop in N will have no impact on economic welfare. However, if we introduce sticky prices and wages in the model then unexpected changes in N will reduce welfare in the traditional neo-classical sense. Hence, to ensure Pareto optimality we have two options.

1) The monetary institutional set-up should ensure a stable and predictable N. We can do that with a central bank that targets the NGDP level or with a Free Banking set-up (that ensures a stable N in a perfect competition Free Banking system). Hence, while Market Monetarists mostly argue in favour of NGDP from a macroeconomic perspective David Eagle’s framework also gives a strong welfare theoretical argument for NGDP targeting.

2) (Full) Quasi-Real Indexing (QRI) will also ensure a Pareto optimal outcome – even with stick prices and wages and changes in N. David Eagle and Dale Domian have argued that QRI could be used to “immunise” the economy from recessions. Market Monetarists (other than myself) have so far as I know now directly addressed the usefulness of QRI.

Remaining with in the simplified version of the equation of exchange (N=PY) NGDP targeting focuses on left hand side of the equation, which can be determined by monetary policy, while QRI is focused on the right hand side of the equation. Obviously with one of the two in place the other would not be needed.

In my view the main problem with QRI is that the right hand side of the equation is not just one price and one output but millions of prices and outputs and the price system plays a extremely important role in the allocation of resources in the economy. It is therefore also impossible to expect some kind of “centralised” QRI (god forbid anybody would get such an idea…). I am pretty sure that my fellow Market Monetarist bloggers feel the same way. That said, I think that QRI can useful in understanding why the drop in nominal spending (N) has had such a negative impact on RGDP in the US and other places.

Furthermore, as I stressed in an earlier post QRI might be useful in housing funding reform in the US – as suggested by David Eagle. Furthermore, it is obviously QRI based government bonds could be used in the conduct of NGDP targeting – as in line with what Scott Sumner for example has suggested and as in fact also suggested by David Eagle.

David Eagle should inspire Market Monetarists

In conclusion I think that David Eagle’s and Dale Damion’s on work on both NGDP targeting and QRI will be a useful input to the further development of the Market Monetarist paradigm and I especially think it will be helpful in a more precise description of the micro-foundation of Market Monetarism.

PS David Eagle has also done work on interest rates targeting and is highly critical of Michael Woodford’s New Keynesian perspective on monetary policy. This research is relatively technical and not easily assessable, but should surely be of interest to Market Monetarists as well.

What Steve suggests is what he calls “the MMTer’s guaranteed employment scheme”. For those who are not following the monetary debate in blogosphere it might be helpful to tell that MMT means Modern Monetary Theory – or what in the old days was known as Chartalism. I don’t want to use too much time explaining Chartalism (I am not really that strong on what they think), but lets just say that MMTer’s fundamentally think that monetary policy and fiscal policy is the same thing and that money enters circulation through government spending.

Steve’s idea is the following:

“My personal preferred stabilizer is to up the EITC bigtime, expand it up the income spectrum, pay it on weekly paychecks, and index its benefit levels to some measure of unemployment.”

EITC for those who don’t know it means “Earned Income Tax Credit” and is a Federal tax credit given to low income families in the US.

Steve does not say it directly, but I guess that his idea is that the Federal Reserve should fund this scheme. Or at least for a monetarist or a Market Monetarist this is crucial if the programme is going to “work”.

Some would consider Steve Roth’s idea to be completely insane. I do not. However, I have a number of reservations, but most important I have serious trouble with Steve’s premise.

I fundamentally think that recessions are always and everywhere a monetary phenomenon and hence monetary and fiscal policy should not be designed to be “countercyclical”. Monetary policy should be designed not mess with Say’s Law or said in another way monetary policy should not create recessions in the first place. If central banks where to engage in countercyclical policies then it basically end up fighting against it’s own past mistakes. This is also why I so strongly oppose when some Market Monetarists call for “monetary stimulus” as it exactly sounds as if we would like central banks to follow some kind of “countercyclical” policy.

Therefore there is no need for an “employment scheme” if central banks stop messing with Say’s Law by introducing credible NGDP level targeting.

That said, Roth’s scheme might not be in conflict with the idea of NGDP target. In fact if the Federal Reserve said that it in the future would say it would send each a American a cheque of the same size as the average EITC (hence doubling the EITC cheque) and that it would do so until NGDP had returned to the pre-crisis level then that in my view most likely would be a successful mechanism for returning NGDP to the pre-crisis trend. That does not mean that I endorse Steve’s scheme and and the fact that I think it would “work” does not mean that I in anyway agree with MMT theories – I don’t. The only thing it really means is that I think monetary policy is very powerful and that NGDP always can be increased by the use of monetary policy – then it is less important how you inject the money into the economy.

Fundamentally I think it is a pretty bad idea to have the central bank funding government expenditure and given central banks exist I believe they would be made independent of political pressures.

Finally, a comment on my headline. When I read Steve’s comment I came to think of a paper Milton Friedman wrote back in 1948 “A Monetary and Fiscal Framework for Economic Stability”. In the paper Friedman suggests something similar to Steve. Friedman’s suggestion is basically that the government should balance its budgets over the “business cycle”, but in downturns the central bank should print money to finance the public deficits. That in Friedman’s view creates a monetary-fiscal stabiliser of the economy. Friedman luckily became wiser as he aged. Here is a he said about in 1960 in “A Program for Monetary Stability” about his 1948 proposal:

“I have become increasingly persuaded that the proposal is more sophisticated and complex than is necessary, that a much simpler rule would also produce highly satisfactory results and would have two great advantages: first, its simplicity would facilitate the public understanding and backing that is necessary if the rule is to provide an effective barrier to opportunistic “tinkering”; second, it would largely separate the monetary problem from the fiscal and hence would require less far-reaching reform over a narrower area.”

So Steve, I don’t think we need to get the central bank involved in getting NGDP back on track and monetary policy should not be funding government programmes – especially not programmes that are not to great to begin with.

PS Steve, you have one advantage in the debate with me. Friedman suggested in 1948 to use a monetary-fiscal stabiliser and the EITC is of course a (bad) variation of Friedman’s suggestion for a Negative Income Tax and I hate arguing against any of Friedman’s ideas.

I have come to realize that many when they hear about NGDP targeting think that it is in someway a counter-cyclical policy – a (feedback) rule to stabilize real GDP (RGDP). This is far from the case from case and should instead be seen as a rule to ensure monetary neutrality.

The problem is that most economists and none-economists alike think of the world as a world more or less without money and their starting point is real GDP. For Market Monetarist the starting point is money and that monetary disequilibrium can lead to swings in real GDP and prices.

The starting point for the traditional Taylor rule is basically a New Keynesian Phillips curve and the “input” in the Taylor rule is inflation and the output gap, where the output gap is measured as RGDP’s deviation from some trend. The Taylor rule thinking is basically the same as old Keynesian thinking in the sense that inflation is seen as a result of excessive growth in RGDP. For Market Monetarists inflation is a monetary phenomenon – if money supply growth outpaces money demand growth then you get inflation.

Our starting point is not the Phillips curve, but rather Say’s Law and the equation of exchange. In a world without money Say’s Law holds – supply creates it’s own demand. Said in another way in a barter economy business cycles do not exist. It therefore follows logically that recessions always and everywhere is a monetary phenomenon.

Monetary policy can therefore “create” a business cycle by creating a monetary disequilibrium, however, in the absence of monetary disequilibrium there is no business cycle.

So while economists often talk of “money neutrality” as a positive concept Market Monetarists see monetary neutrality not only as a positive concept, but also as a normative concept. Yes, money is neutral in that sense that higher money supply growth cannot increase RGDP in the long run, but higher money supply growth (than money demand growth) will increase inflation and NGDP in the long run.

However, money is not neutral in the short-run due to for price and wage rigidities and therefore money disequilibrium and monetary disequilibrium can therefore create business cycles understood as a general glut or excess supply of goods and labour. Market Monetarists do not argue that the monetary authorities should stabilize RGDP growth, but rather we argue that the monetary authorities should avoid creating a monetary disequilibrium.

So why so much confusing?

I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically” (remember the Chuck Norris effect) if the central bank would implement a strict NGDP level target.

So when Market Monetarists like Scott Sumner has called for “monetary stimulus” it NOT does mean that he wants to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply. (See also my earlier post on “monetary stimulus”)

I have previously argued that when a NGDP target is credible market forces will ensure that any overshoot/undershoot in money supply growth will be counteracted by swings in velocity in the opposite direction. Similarly one can argue that monetary policy mistakes can create swings in velocity, which is the same as to say hat monetary policy mistakes creates monetary disequilibrium.

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo. We should stop that and we should instead focus on “microsovereignty”

NGDP level targeting ensures microsovereignty

A good way to structure the discussion about monetary policy or rather monetary policy regimes is to look at the crucial difference between what Larry White has termed a “macroinstrumental” approach and a “microsovereignty” approach.

The Taylor rule is a typical example of the macroinstrumental approach. In this approached it is assumed that it is the purpose of monetary policy to “maximise” some utility function for society with includes a “laundry list” of more or less randomly chosen macroeconomic goals. In the Taylor rule this the laundry list includes two items – inflation and the output gap.

The alternative approach to choose a criteria for monetary success (as Larry White states it) is the microsovereignty approach – micro for microeconomic and sovereignty for individual sovereignty.

The microsovereignty approach states that the monetary regime should ensure an institutional set-up that allows individuals to make decisions on consumption, investment and general allocation without distortions from the monetary system. More technically the monetary system should ensure that individuals can “capture” Pareto improvements.

This is basically a traditional neo-classical welfare economic approach to monetary theory. We should choose a monetary regime that “maximises” welfare by ensuring individual sovereignty.

A monetary regime that ensures microsovereignty does not have the purpose of stabilising the business cycle, but it will nonetheless be the likely consequence as NGDP level targeting removes or at least strongly reduces monetary disequilibrium and as recessions is a monetary phenomenon this will also strongly reduce RGDP and price volatility. This is, however, a pleasant consequence but not the main objective of NGDP level targeting.